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Apple Earnings: Playing the Guidance Game -- and Winning

By Evan Niu, CFA – Updated Aug 2, 2017 at 2:07PM

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Next quarter could be the best September quarter Apple has ever posted.

And you thought the June quarter was supposed to be boring.

Well, it normally is. But this time around, Apple's (AAPL -0.91%) fiscal third-quarter earnings release on Tuesday was so strong that it helped push shares to all-time highs in after-hours trading.

Revenue totaled $45.4 billion, of which $8.7 billion trickled down to the bottom line in the form of net income, or $1.67 per share. iPhone unit sales came in better than expected at 41 million, which is particularly impressive considering the fact that rumors about the next iPhone continue to circulate. That normally puts a more meaningful damper on demand. To be clear, high expectations for the 10th-generation iPhone are still hurting sales, just not as badly as they could be. Apple has now sold 1.2 billion iPhones to date.

Tim Cook holding the billionth iPhone in front of Apple employees

Apple CEO Tim Cook holding the billionth iPhone. Image source: Apple.

The iPad comeback?

Here's something you don't hear every Apple earnings release: The iPad crushed it. For the past few years, the iPad's financial performance has stagnated. Unit sales have mostly trended lower and average selling prices (ASPs) remain flat, in part since upgrade cycles are proving to be longer than expected. The company has elongated product cycles in response, all while trying to introduce new features into new iPads at relatively comparable price points. It hasn't worked. But Apple has finally figured out the key to unlocking iPad unit sales: Take a page out of the iPhone SE playbook.

iPad unit sales jumped 15% to 11.4 million, far surpassing expectations of around 9 million. This is what a collective sigh of relief looks like:

Chart showing a spike in iPad unit growth

Data source: SEC filings. Chart by author. Calendar quarters shown.

There were two important iPad introductions that affected the quarter. First, Apple introduced its new $329 iPad in March (before the second quarter). While there's some cannibalization risk, Apple then proceeded to launch a new 10.5-inch iPad Pro at WWDC in June (at the tail end of the second quarter). Combined, these two products helped drive iPad volumes. "The approach we've had from a product point of view, of bifurcating iPad and iPad Pro, is really resonating with our users," CEO Tim Cook said on the call.

Sure, Apple has released iPad Mini models that are comparable in price to $329, and Apple has offered older 9.7-inch models at similar prices as well, but you can tell that the two-pronged strategy is working since iPad ASPs were flat sequentially but unit sales skyrocketed. The 9.7-inch form factor is extremely popular, and combining that display size with more current specs like an A9 processor is clearly working.

Services keeps growing

Apple's services business continues to march higher, jumping 22% during the quarter to $7.3 billion in sales -- a new quarterly record. On a trailing-12-month basis, services is now a $27.8 billion business. There are now 185 million paid subscriptions across Apple's digital stores, up from 165 million last quarter and 150 million the quarter before that.

The company did not give an update on how many Apple Music subscriptions there are, only saying that Apple Music and iCloud storage are helping drive gains.

Greater China still weak

Once a point of pride, Greater China remains a soft spot these days. Sales in the Middle Kingdom fell 25% sequentially and 10% year over year, down to $8 billion. Local competition continues to intensify from low-cost vendors, and it seems that Apple is losing some of the brand cachet that it once enjoyed in China. Cook once predicted that China would eventually become Apple's largest market, but its performance is slipping along with that goal.

Chart comparing TTM revenue in the U.S. vs China

Data source: SEC filings. Chart by author. Calendar quarters shown.

For a while there in 2015, Greater China was catching up to the U.S., but it has since slipped. Apple just recently named Isabel Ge Mahe as managing director of Greater China, a newly created position. She has been with the company for nearly a decade, and hopefully can help fix Apple's woes.

The guidance game

Guidance was the strongest part of the report. Apple expects revenue in the fiscal fourth quarter to be in the range of $49 billion to $52 billion. At the midpoint, that outlook represents a return to growth -- 8%, to be precise. Sales posted a decline in the year-ago quarter. More to the point, the high end of that guidance would be an all-time record for the September quarter (by about $500 million). With all of the rumors about potential "iPhone 8" delays, the forecast is helping to alleviate investors' fears.

The iPhone 7 launched last year with about two weeks left in the quarter, so the outlook is effectively predicting a highly successful and punctual launch this year. The counterpoint is that after the initial launch, it remains unclear if Apple can sufficiently ramp production and meet the rest of demand, since there will certainly be more than a few weeks of demand. It's also possible that Apple is expecting a big jump in iPhone ASPs, given what we've heard about possible pricing, and it might be able to hit that guidance on fewer units if manufacturing yields truly are low.

Gross margin is expected to be 37.5% to 38%, a sequential downtick as the memory pricing environment remains unfavorable.

Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has a disclosure policy.

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